Xan Myburgh is CEO + Co-Founder Support Business Fundinga leading alternative financing solution.
Funding is something every business has to deal with when trying to grow. As a dedicated business owner, you probably know these struggles better than anyone. So, what is the right move for your business, a line of credit or a term loan? The best place to start is to understand the difference between the two, and as the CEO and co-founder of a company that offers financial options to business clients, I am intimately familiar with the attributes of both.
What is a line of credit?
A line of credit is a common form of financing. A credit line assigned by a lender is similar to a credit card you can use. This means that the amount borrowed can be used, repaid and then used again. Once you have this new line of credit, you can use it for whatever you think is most necessary for your business, such as:
- Purchase new inventory or replenish existing inventory.
- Financing new marketing strategies.
- Extra cash for seasonal fluctuations.
Typically, a line of credit is used when you need extra money to cover short-term expenses. That’s why they have higher interest rates and lower average dollar amounts.
It is important to note that there are two types of lines of credit, secured and unsecured. To obtain a secured line of credit, your business will need to pledge specific assets as collateral to “secure” the funds. Where the line of credit is typically a short-term liability, the lender will require that the collateral be a short-term asset such as inventory.
Getting an unsecured line of credit is more difficult to obtain because it requires no collateral. To provide some security to the lender, the lender will require a lien or personal guarantee to make the payment. A strong personal credit score may be required to obtain an unsecured line of credit.
What is a term loan?
Loans are non-revolving, with large one-time disbursements. You then make principal and interest payments until the debt is paid off in full. Loans can also be secured and unsecured. For example, traditional bank loans always require some form of collateral.
Another disadvantage of term loans is that they can only be used for a single purpose. This means that if you take out a loan to pay your wages, you won’t be able to use a penny of that money to buy inventory or repair equipment.
What are the pros and cons of a line of credit?
Pay for what you need: A line of credit allows your business to have a maximum balance, the maximum estimated cost of all your expenses that you will need to cover. Then you only pay interest on the amount you need and use.
Boost cash flow: A line of credit is an easy way to ensure that even in a tough month or quarter, you’ll still make all your payments on time. Businesses that are heavily affected by the seasons often take full advantage of this form of financing.
Work around your schedule: With a line of credit, you can withdraw the amount you want at any time. You can then pay it back with interest on your own schedule (this will vary).
Improve credit: In order to get a better loan, you usually need a higher credit score to apply. A good way to build that score is to build a positive credit history with a business line of credit by making payments on time.
interest rate: I mentioned this before, but one of the most notable downsides to a line of credit is how high the average interest rate is. These rates are variable and can exceed 25% in some cases, depending on the length of the term, credit limit and your credit score.
lower limit: Another common pain point for businesses associated with lines of credit is that the limits on lines of credit are much lower compared to traditional loans through banks.
While the advantages of credit lines seem to outweigh the disadvantages of their specific use cases, that doesn’t stop businesses from legitimately worrying about some potential pitfalls.
Are credit lines at risk?
All types of loans carry risks. I advise all businesses to be aware of hidden risks that lenders won’t warn you about, such as monthly maintenance fees. While the initial cost of obtaining a line of credit is relatively low, variable rates that rise as the market size increases can end up being more expensive than expected. Another risk that is often overlooked is not making minimum payments. This could result in a complete shutdown of the line and liability to your business or you personally. So, how to recover the credit line? Because you are borrowing incrementally, you will repay the original amount, then borrow again as long as the line remains open.
One way to avoid some of the risks associated with a business line of credit is through reliable and trustworthy alternative sources of financing. Many alternative lenders offer a wide range of lines of credit. Some alternative lenders also tailor business financing to your needs by adjusting payment options for daily, weekly or semi-monthly payments. Lines of credit also offer unlimited terms and have a soft credit pull that won’t affect your credit score.
What’s easier to get, a term loan or a line of credit?
The real question is whether a traditional business loan is easier to get than a line of credit. Credit limits come out on top in this comparison. As with many of the advantages listed above, one of the best reasons to choose a line of credit over a conventional loan comes down to the flexibility it affords you, which is ideal for the inconsistent nature of a small business. Smaller or newer businesses may struggle to make any headway in securing a bank loan, but obtaining a line of credit may be relatively easy.
The information presented here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.
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